Eric Leeper's Home Page

Joint with Nora Traum and Todd B. Walker. Bayesian prior predictive analysis of five nested DSGE models suggests that model specifications and prior distributions tightly circumscribe the range of possible government spending multipliers. Multipliers are decomposed into wealth and substitution effects, yielding uniform comparisons across models. By constraining the multiplier to tight ranges, model and prior selections bias results, revealing less about fiscal effects in data than about the lenses through which researchers choose to interpret data. When monetary policy actively targets inflation, output multipliers can exceed one, but investment multipliers are likely to be negative. Passive monetary policy produces consistently strong multipliers for output, consumption, and investment.

Joint with Alex Richter and Todd Walker. Changes in fiscal policy typically entail two kinds of lags: the legislative lag—between when legislation is proposed and when it is signed into law—and the implementation lag—from when a new fiscal law is enacted and when it takes effect. These lags imply that substantial time evolves between when news arrives about fiscal changes and when the changes actually take place—time when households and firms can adjust their behavior. We identify two types of fiscal news—government spending and changes in tax policy. We identify news concerning taxes through the municipal bond market, and news concerning government spending through the Survey of Professional Forecasters. The main contribution of the paper is a mapping from reduced-form estimates of news into a DSGE framework. We argue that news about fiscal policy is a time-varying process. We demonstrate that the ignoring the time variation can have important consequences in a conventional macroeconomic model.

Joint with Todd B. Walker. The Great Recession and worldwide financial crisis have exploded fiscal imbalances and brought fiscal policy and inflation to the forefront of policy concerns. Those concerns will only grow as aging populations increase demands on government expenditures in coming decades. It is widely perceived that fiscal policy is inflationary if and only if it leads the central bank to print new currency to monetize deficits. Monetization can be inflationary. But it is a \emph{mis}perception that this is the only channel for fiscal inflations. Nominal bonds, the predominant form of government debt in advanced economies, derive their value from expected future nominal primary surpluses and money creation; changes in the price level can align the market value of debt to its expected real backing. This introduces a fresh channel, not requiring monetization, through which fiscal deficits directly affect inflation. The paper begins by pointing out similarities and differences between the Weimar Republic after World War I and the United States today. It describes various ways in which fiscal policy can directly affect inflation and explains why these fiscal effects are difficult to detect in time series data.

Joint with Huixin Bi and Campbell Leith. In a non-linear New Keynesian economy, we explore the macro-economic consequences of undertaking state-dependent fiscal consolidations of uncertain timing and composition. Following the empirical evidence in Alesina and Ardagna (2010), we place particular emphasis on whether or not the fiscal consolidation is driven by tax rises or expenditure cuts. We find that the composition of the fiscal consolidation, its duration, the monetary policy stance, the level of government debt, the degree of price stickiness, and expectations over the likelihood and composition of fiscal consolidations all matter in determining the extent to which a given consolidation is expansionary and/or successful.

Joint with Todd B. Walker and Shu-Chun Susan Yang. News--or foresight--about future economic fundamentals can create rational expectations equilibria with non-fundamental representations that pose substantial challenges to econometric efforts to recover the structural shocks to which economic agents react. Using tax policies as a leading example of foresight, simple theory makes transparent the economic behavior and information structures that generate non-fundamental equilibria. Econometric analyses that fail to model foresight will obtain biased estimates of output multipliers for taxes; biases are quantitatively important when two canonical theoretical models are taken as data generating processes. Both the nature of equilibria and the inferences about the effects of anticipated tax changes hinge critically on hypothesized tax information flows. Differential U.S. federal tax treatment of municipal and treasury bonds embeds news about future taxes in bond yield spreads. Including that measure of tax news in identified VARs produces substantially different inferences about the macroeconomic impacts of anticipated taxes.

Joint with Todd B. Walker. Aging populations in advanced economies are placing ever-increasing demands on government spending in the form of old-age benefits. Economies that have made more promises of benefits than they have plans to finance them are heading into a prolonged era of fiscal stress. Unresolved fiscal stress raises the possibility the economies will hit their fiscal limits where taxes and spending no longer adjust to stabilize debt. In such economies, monetary policy may lose its ability to control inflation and influence the economy in the usual ways. The paper discusses models of fiscal limits and their implications and lays out a research agenda to integrate political economy and empirical considerations with general equilibrium models of monetary and fiscal interactions. Here is the cover page for the special issue of Economic Papers: A Journal of Applied Economics and Policy and here are all the papers from the Australian Symposium on Monetary-Fiscal Interactions.

Joint with Huixin Bi and Campbell Leith. Incomplete draft. Prepared for the European Central Bank's conference on "Monetary and Fiscal Policy Challenges in Times of Financial Stress,'' December 2-3, 2010. Worldwide monetary and fiscal policies in the past few years have put into sharp relief the fundamental tradeoff between short-run stabilization and long-run sustainability that policymakers face. The paper is organized around this question: How do the effects of routine monetary and fiscal operations designed to achieve macroeconomic stabilization objectives change when the economy moves from a debt-GDP level where the probability of default is nil to a higher level---the "fiscal limit''---where that default probability is non-negligible? Three main results emerge. First, when the economy is near its fiscal limit a transitory monetary policy contraction reduces output more, and it reduces inflation only in the very short run, before leading to a sustained rise in inflation in the medium term. Second, higher government spending may be appreciably more inflationary when the economy is staring at its fiscal limit. These effects arise even though monetary policy actively target inflation and fiscal policy passively adjusts taxes to stabilize debt. Third, specification of the central bank's instrument---risky versus risk-free short-term nominal interest rate---matters for the link between expected default rates and inflation.

Joint with Troy Davig. Many advanced economies are heading into an era of fiscal stress: populations are aging and governments have made substantially more promises of old-age benefits than they have made provisions to finance. This paper models the era of fiscal stress as stemming from growing promised government transfers that initially are fully honored, being financed by new sales of government debt that bring forth higher future income taxes. As debt levels and tax rates rise, the population's tolerance for taxation declines and the probability of reaching the fiscal limit increases. At the limit a fixed tax rate is adopted, adjustments in taxes no longer stabilize debt, and, temporarily, debt grows rapidly. Eventually, a new stabilizing combination of policies is adopted. We examine how, in the period before the fiscal limit, rapidly rising debt interacts with expectations of how and when policies will adjust. If households believe it is possible that in the future monetary policy will shift from targeting inflation to stabilizing debt, then temporarily explosive debt feeds directly into the path of inflation. News that reduces expected primary surpluses can bring future inflation into the present, well before the news shows up in fiscal measures. This paper makes the point that even if long-run policies give monetary policy perfect control over inflation, in the transition to that long run, monetary policy can spectacularly lose control.

Joint with Troy Davig and Todd B. Walker. We use a rational expectations framework to assess the implications of rising debt in an environment with a ``fiscal limit.’’ The fiscal limit is defined as the point where the government no longer has the ability to finance higher debt levels by increasing taxes, so either an adjustment to fiscal spending or monetary policy must occur to stabilize debt. We give households a joint probability distribution over the various policy adjustments that may occur, as well as over the timing of when the fiscal limit is hit. One policy option that stabilizes debt is a passive monetary policy, which generates a burst of inflation that devalues the existing nominal debt stock. The probability of this outcome places upward pressure on inflation expectations and poses a substantial challenge to a central bank pursuing an inflation target. The distribution of outcomes for the path of future inflation has a fat right tail, revealing that only a small set of outcomes imply dire inflationary scenarios. Avoiding these scenarios, however, requires the fiscal authority to renege on some share of future promised transfers. Published in European Economic Review.

Prepared for the Jackson Hole Symposium. Monetary policy decisions tend to be based on systematic analysis of alternative policy choices and their associated macroeconomic impacts: this is science. Fiscal policy choices, in contrast, spring from unsystematic speculation, grounded more in politics than economics: this is alchemy. In normal times, fiscal alchemy poses no insurmountable problems for monetary policy because fiscal expectations can be extrapolated from past fiscal behavior. But normal times may be coming to an end: aging populations are causing promised government old-age benefits to grow relentlessly and many governments have no plans for financing the benefits. In this era of fiscal stress, fiscal expectations are unanchored and fiscal alchemy creates unnecessary uncertainty and can undermine the ability of monetary policy to control inflation and influence real economic activity in the usual ways. Presentation slides.

Joint with Huixin Bi. Prepared for the Swedish Fiscal Policy Council. This paper takes a step toward providing a general equilibrium framework within which to study the nub of the current fiscal debate around the world: what are the tradeoffs between short-run stabilization and long-run sustainability when the perceived riskiness of government debt depends, in part, on the current and expected fiscal environment in place? We calibrate a simple model to Swedish fiscal data in two periods: before and after the financial crisis of the early 1990s. We compute the dynamic fiscal limit, which depends on the peak of the Laffer curve, for the pre-crisis and three alternative post-crisis fiscal policies. The model simulates the macroeconomic consequences of alternative policies in the face of the sequence of bad output shocks that Sweden experienced from 1991-1997.

Joint with Todd B. Walker. How do information flows influence business cycle dynamics in models with anticipated (news shocks) and unanticipated innovations? To address this question, we show how alternative specifications of news affect the equilibrium by deriving the mapping between news shocks and the endogenous variables in a simple analytical model. News shocks are shown to add moving average (MA) components to endogenous variables. We then show how the additional MA components affect equilibrium dynamics. We generalize two popular forms of news processes to demonstrate how information flows impact equilibrium dynamics. To compare these news processes, we establish conditions under which the two processes have identical information content. We find that allowing news shocks to be correlated across time generates hump-shaped impulse response functions and helps mitigate the comovement problem. Published in Review of Economic Dynamics.

Slow moving demographics are aging populations around the world and pushing many countries into an extended period of heightened fiscal stress. In some countries, taxes alone cannot or likely will not fully fund projected pension and health care expenditures. If economic agents place sufficient probability on the economy hitting its ``fiscal limit'' at some point in the future---after which further tax revenues are not forthcoming---it may no longer be possible for ``good'' monetary policy behavior to control inflation or anchor inflation expectations. In the period leading up to the fiscal limit, the more aggressively that monetary policy leans against inflationary winds, the more expected inflation becomes unhinged from the inflation target. Problems confronting monetary policy are exacerbated when policy institutions leave fiscal objectives and targets unspecified and, therefore, fiscal expectations unanchored. Prepared for the Central Bank of Chile's 13th Annual Conference, November 19 and 20, 2009. Forthcoming in Monetary Policy under Financial Turbulence, edited by Luis Felipe Céspedes, Roberto Chang, and Diego Saravia, Santiago, Chile.

Joint with Troy Davig and Todd B. Walker. We develop a rational expectations framework to study the consequences of alternative means to resolve the ``unfunded liabilities'' problem---unsustainable exponential growth in federal Social Security, Medicare, and Medicaid spending with no plan to finance it. Resolution requires specifying a probability distribution for how and when monetary and fiscal policies will change as the economy evolves through the 21st century. Beliefs based on that distribution determine the existence of and the nature of equilibrium. We consider policies that in expectation combine reaching a fiscal limit, some distorting taxation, modest inflation, and some reneging on the government's promised transfers. In the equilibrium, inflation-targeting monetary policy cannot successfully anchor expected inflation. Expectational effects are always present, but need not have large impacts on inflation and interest rates in the short and medium runs. Prepared for the Carnegie-Rochester Conference Series on Public Policy, ``Fiscal Policy in an Era of Unprecedented Budget Deficits,'' November 13-14, 2009. Published in Carnegie-Rochester Conference Series on Public Policy published by Journal of Monetary Economics.

Draws on my public lecture on November 12, 2008 in Wellington, NZ, part of my tenure as a Professorial Fellow in Monetary and Financial Economics at Victoria University of Wellington and the Reserve Bank of New Zealand. In this lecture, I argue that there are remarkable parallels between how monetary and fiscal policies operate on the macro economy and that these parallels are sufficient to lead us to think about transforming fiscal policy and fiscal institutions as many countries have transformed monetary policy and monetary institutions. Making fiscal transparency comparable to monetary transparency requires fiscal authorities to discuss future possible fiscal policies explicitly. Enhanced fiscal transparency can help anchor expectations of fiscal policy and make fiscal actions more predictable and effective. As advanced economies move into a prolonged period of heightened fiscal activity, anchoring fiscal expectations will become an increasingly urgent need. Published in Reserve Bank of New Zealand Bulletin and Sveriges Riksbank Economic Review.

Joint with Michael Plante and Nora Traum. Dynamic stochastic general equilibrium models that include policy rules for government spending, lump-sum transfers, and distortionary taxation on labor and capital income and on consumption expenditures are fit to U.S. data under a variety of specifications of fiscal policy rules. We obtain several results. First, the best fitting model allows a rich set of fiscal instruments to respond to stabilize debt. Second, responses of aggregate variables to fiscal policy shocks under rich fiscal rules can vary considerably from responses that allow only non-distortionary fiscal instruments to finance debt. Third, based on estimated policy rules, transfers, capital tax rates, and government spending have historically responded strongly to government debt, while labor taxes have responded more weakly. Fourth, all components of the intertemporal condition linking debt to expected discounted surpluses---transfers, spending, tax revenues, and discount factors---display instances where their expected movements are important in establishing equilibrium. Fifth, debt-financed fiscal shocks trigger long lasting dynamics so that short-run multipliers can differ markedly from long-run multipliers, even in their signs. Estimation appendix. Published in Journal of Econometrics. Zipped file with code.

Joint with Todd Walker and Shu-Chun Yang. This paper contributes to the debate about fiscal multipliers by studying the impacts of government investment in conventional neoclassical growth models. The analysis focuses on two dimensions of fiscal policy that are critical for understanding the effects of government investment: implementation delays associated with building public capital projects and expected future fiscal adjustments to debt-financed spending. Implementation delays can produce small or even negative labor and output responses in the short run; anticipated fiscal financing adjustments matter both quantitatively and qualitatively for long-run growth effects. Taken together, these two dimensions have important implications for the short-run and long-run impacts of fiscal stimulus in the form of higher government infrastructure investment. The analysis is conducted in several models with features relevant for studying government spending, including utility-yielding government consumption, time-to-build for private investment, and government production. Published in Journal of Monetary Economics.

Joint with Troy Davig. Increases in government spending trigger substitution effects---both inter- and intra-temporal---and a wealth effect. The ultimate impacts on the economy hinge on current and expected monetary and fiscal policy behavior. Studies that impose active monetary policy and passive fiscal policy typically find that government consumption crowds out private consumption: higher future taxes create a strong negative wealth effect, while the active monetary response increases the real interest rate. This paper estimates Markov-switching policy rules for the United States and finds that monetary and fiscal policies fluctuate between active and passive behavior. When the estimated joint policy process is imposed on a conventional new Keynesian model, government spending generates positive consumption multipliers in some policy regimes and in simulated data in which all policy regimes are realized. The paper reports the model's predictions of the macroeconomic impacts of the American Recovery and Reinvestment Act's implied path for government spending under alternative monetary-fiscal policy combinations. Published in European Economic Review. Zipped code for the paper.

Joint with Troy Davig. Farmer, Waggoner, and Zha (2009) show that a new Keynesian model with a regime-switching monetary policy rule can support multiple solutions that depend only on the fundamental shocks in the model. Their note appears to find solutions in regions of the parameter space where there should be no bounded solutions, according to conditions in Davig and Leeper (2007). This puzzling finding is straightforward to explain: Farmer, Waggoner, and Zha (FWZ) derive solutions using a model that differs from the one to which the Davig and Leeper conditions apply. FWZ's multiple solutions rely on special assumptions about the correlation structure between fundamental shocks and policy regimes, blurring the distinction between "deep" parameters that govern behavior and the parameters that govern the exogenous shock processes, and making it difficult to ascribe any economic interpretation to FWZ's solutions. Published in American Economic Review.

Joint with Todd Walker and Shu-Chun Yang. Fiscal foresight---the phenomenon that legislative and implementation lags ensure that private agents receive clear signals about the tax rates they face in the future---is intrinsic to the tax policy process. This paper develops an analytical framework to study the econometric implications of fiscal foresight. Simple theoretical examples show that foresight produces equilibrium time series with nonfundamental representations, which misalign the agents' and the econometrician's information sets. Economically meaningful shocks to taxes, therefore, cannot generally be extracted from statistical innovations in conventional ways. Econometric analyses that fail to align agents' and the econometrician's information sets can produce distorted inferences about the effects of tax policies. The paper documents the sensitivity of econometric inferences of tax effects to details about how tax information flows into the economy. We show that alternative assumptions about the information flows that give rise to fiscal foresight can reconcile the diverse empirical findings in the literature on anticipated tax changes. Research supported by NSF Grant SES-0452599.

Joint with Todd Walker and Shu-Chun Yang. A companion piece to "Fiscal Foresight and Information Flows." Repeats some of the results in the other paper but contains a number of different results. Fiscal foresight—the phenomenon that legislative and implementation lags ensure that private agents receive clear signals about the tax rates they face in the future—is intrinsic to the tax policy process. This paper develops an analytical framework to study the econometric implications of fiscal foresight. Simple theoretical examples show that foresight produces equilibrium time series with a non-invertible moving average component, which misaligns the agents’ and the econometrician’s information sets in estimated VARs. Economically meaningful shocks to taxes, therefore, cannot be extracted from statistical innovations in conventional ways. Econometric analyses that fail to align agents’ and the econometrician’s information sets can produce distorted inferences about the effects of tax policies. Because non-invertibility arises as a natural outgrowth of the fact that agents’ optimal decisions discount future tax obligations, it is likely to be endemic to the study of fiscal policy. In light of the implications of the analytical framework, we evaluate two existing empirical approaches to quantifying the impacts of fiscal foresight. The paper alsooffers a formal interpretation of the narrative approach to identifying fiscal policy. Research supported by NSF Grant SES-0452599.

Joint with Hess Chung. Dynamic rational expectations models imply that the real value of debt in the hands of the public must be equal to the expected present-value of surpluses. We impose this equilibrium condition on an identified VAR and characterize the way in which the present-value support of debt varies across various types of fiscal policy shocks and between fiscal and non-fiscal shocks. The role of expected primary surpluses in supporting innovations to debt depends on the nature of the shock. For some fiscal policy shocks, debt is supported almost entirely by changes in the present-value of surpluses, however, in the case of other fiscal policy shocks, surpluses fail to adjust and instead leave a large role for expected changes in discount rates. Horizons over which debt innovations are financed are long---on the order of fifty years---while present-values calculated up to any finite horizon up to then fluctuate wildly, particularly following government spending and transfer shocks. Research supported by NSF Grant SES-0452599.

Joint with Troy Davig. Prepared for the NBER International Seminar on Macroeconomics meeting in Tallinn, Estonia, June 16-17, 2006. This paper makes changes in monetary policy rules (or regimes) endogenous. Changes are triggered when certain endogenous variables cross specified thresholds. Rational expectations equilibria are examined in three models of threshold switching to illustrate that (i) expectations formation effects generated by the possibility of regime change can be quantitatively important; (ii) symmetric shocks can have asymmetric effects; (iii) endogenous switching is a natural way to formally model preemptive policy actions. In a conventional calibrated model, preemptive policy shifts agents' expectations, enhancing the ability of policy to offset demand shocks; this yields a quantitatively significant "preemption dividend." Research supported by NSF Grant SES-0452599. Published in NBER ISOM.

Joint with Shu-Chun Susan Yang. Neoclassical growth models predict positive growth effects over the entire transition path following a reduction in capital or labor tax rates when lump-sum taxes (or transfers) are used to balance the government budget. This paper considers the consequences of bond-financed tax reductions that bring forth adjustments in expected future government consumption, capital tax rates, or labor tax rates. Through the resulting intertemporal distortions, current tax cuts can lower growth. Consequently, static scoring of tax revenue impacts, which assumes no feedback from taxes to national income, does not necessarily overstate the revenue loss when compared with dynamic scoring. Research supported by NSF Grant SES-0452599. Published in Journal of Public Economics.

Joint with James M. Nason. The government budget constraint is an accounting identity linking the monetary authority's choices of money growth or nominal interest rate and the fiscal authority's choices of spending, taxation, and borrowing at a point in time and across time. The intertemporal links create a rich set of possible outcomes from standard macro policy experiments. Taking the government budget constraint seriously can overturn some widely held beliefs about policy effects. Forthcoming in Blume, Lawrence and Steven N. Durlauf, eds., The New Palgrave Dictionary of Economics, 2^nd Edition (Hampshire, England: Palgrave Macmillan Ltd.). Research supported by NSF Grant SES-0452599.

Joint with Tack Yun. The paper presents the fiscal theory of the price level in a variety of models, including endowment economies with lump-sum taxes and production economies with proportional income taxes. We offer a microeconomic perspective on the fiscal theory by computing a Slutsky-Hicks decomposition of the effects of tax changes into substitution, wealth, and revaluation effects. Revaluation effects arise whenever tax changes alter the value of outstanding nominal government liabilities by changing the price level. Under certain assumptions on monetary and fiscal behavior, the revaluation effect reflects the fiscal theory mechanism. When taxes distort, two Laffer curves arise, implying that a tax increase can lower or raise the price level and the revaluation effect can be positive or negative, depending on which side of a particular Laffer curve the economy resides. Prepared for the 61st Congress of the International Institute of Public Finance conference "Macro-Fiscal Policies: New Perspectives and Challenges," Jeju Island, South Korea, August 22-25, 2005. Research supported by NSF Grant SES-0452599. Published in International Taxation and Public Finance.

Joint with Troy Davig. This paper estimates regime-switching rules for monetary policy and tax policy over the post-war period in the United States and imposes the estimated policy process on a calibrated dynamic stochastic general equilibrium model with nominal rigidities. Decision rules are locally unique and produce a rational expectations equilibrium in which (lump-sum) tax shocks always affect output and inflation. Tax non-neutralities in the model arise solely through the mechanism articulated by the fiscal theory of the price level. The paper quantifies that mechanism and finds it to be important in U.S. data, reconciling a popular class of monetary models with the evidence that tax shocks have substantial impacts. Because long-run policy behavior determines the qualitative nature of equilibrium, in a regime-switching environment more accurate qualitative inferences can be gleaned from full-sample information than by conditioning on policy regime. Research supported by NSF Grant SES-0452599. Published in NBER Macroeconomics Annual 2006.

Joint with Troy Davig and Hess Chung. A growing body of evidence finds that policy reaction functions vary substantially over different periods in the United States. This paper explores how moving to an environment in which monetary and fiscal regimes evolve according to a Markov process can change the impacts of policy shocks. In one regime monetary policy follows the Taylor principle and taxes rise strongly with debt; in another regime the Taylor principle fails to hold and taxes are exogenous. An example shows that a unique bounded non-Ricardian equilibrium exists in this environment. A computational model illustrates that because agents' decision rules embed the probability that policies will change in the future, monetary and tax shocks always produce wealth effects. When it is possible that fiscal policy will be unresponsive to debt at times, active monetary policy (like a Taylor rule) in one regime is not sufficient to insulate the economy against tax shocks in that regime and it can have the unintended consequence of amplifying and propagating the aggregate demand effects of tax shocks. The paper also considers the implications of policy switching for two empirical issues. Published in Journal of Money, Credit, and Banking.

I was asked to evaluate the Riksbank’s Inflation Reports by Anders Vredin, head of the monetary policy group at Sveriges Riksbank. The assignment included drawing comparisons among the Reports issued by the Riksbank, the Bank of England, and the Reserve Bank of New Zealand. This constitutes the entirety of my instructions. The content of this report, therefore, reflects my own priorities and biases in monetary policy analysis. Although several staff members at the Riksbank have provided constructive comments, they had no influence over the report’s tone, criticisms, or recommendations. Published in Sveriges Riksbank Economic Review 3, 2003, 94-118.

An asset-pricing perspective on inflation reveals that it depends on current and expected monetary and fiscal policies. There are three ways to carry $1 today into the future: money, bonds, and real assets. That dollar’s purchasing power varies inversely with the price level. Expected money growth, tax rates, and government spending directly impinge on these expected rates of return of these assets, and determine the price level and the inflation rate. The paper considers a tax reduction that is financed by new government debt. It examines how alternative responses of current and future policies to the tax cut can imply very different outcomes for inflation. Also appears as NBER Working Paper No. 9506, February. Published in Journal of Investment Management 1, Second Quarter, 2003: 44-59.

Prepared for The Institute for Quantitative Research in Finance (The Q Group) Seminar in Coronado (San Diego), October 6-9, 2002. Inflation depends generically on current and expected monetary and fiscal policies. There are three ways to carry $1 today into the future: money, bonds, and real assets. That dollar's purchasing power varies inversely with the price level. The real return on money depends on the flow of transactions services it supports and the expected inflation rate; the analogous return on bonds is the nominal interest rate, adjusted for risk and expected inflation; the returns on real assets are their marginal products, adjusted for risk. Arbitrages among money balances, bonds, and investment goods determine their relative values and demands. Expected money growth, tax rates, and government spending directly impinge on these expected rates of return and determine the price level and inflation rate. Given an initial tax reduction that is financed by new government debt, the paper considers alternative responses of current and future policies that are feasible, and derives the implications for inflation in several standard environments.

Joint with Tao Zha. We present a framework for computing and evaluating linear projections of macro variables conditional on hypothetical paths of monetary policy. A modest policy intervention is a change in policy that does not significantly shift agents’ beliefs about policy regime and does not generate quantitatively important expectations-formation effects of the kind Lucas (1976) emphasizes. The framework is applied to an econometric model of U.S. postwar monetary policy behavior. It finds that a rich class of interventions routinely considered by the Federal Reserve are modest and their impacts can be reliably forecasted by an accurately identified linear model. Moreover, modest interventions can matter: they may shift the projected paths and probability distributions of macro variables in economically meaningful ways. Also appears as NBER Working Paper No. 9192, September. Published in Journal of Monetary Economics 50, November, 2003, 1673-1700.

Joint with David Gordon. We consider price level determination from the perspective of portfolio choice. Arbitrages among money balances, bonds, and investment goods determine their relative demands. Returns to real balance holdings (transactions services), the nominal interest rate, and after-tax returns to investment goods determine the relative values of nominal and real assets. Since expectations of government policies ultimately determine the expected returns to both nominal and real assets, monetary and fiscal policies jointly determine the price level. Special cases of the fiscal and monetary policies considered produce the quantity theory of money and the fiscal theory of the price level. Also appears as NBER Working Paper No. 9084, July. Published in Scottish Journal of Political Economy.

Joint with Tao Zha. We construct linear projections of macro variables conditional on hypothetical paths of monetary policy, using as an example an identified VAR model. Hypothetical policies are restricted to ones where both the policy intervention and its impacts are consistent with history—otherwise the linear projections are likely to be unreliable. We use the approach to interpret Federal Reserve decisions, modeling their frequent reassessment in light of new information about the tradeoffs policymakers face. The interventions we consider matter: they can shift projected paths and probability distributions of macro variables in economically meaningful ways. Also appears as NBER Working Paper No. 9063, July.

Joint with David B. Gordon. Prepared for the Bundesbank's conference "Monetary Policy: How Relevant are Other Policymakers?" Economists generally believe that countercyclical fiscal policies have stabilizing effects that work through automatic stabilizers and discretionary actions. Analyses underlying this conventional wisdom focus on intratemporal margins: how employment and personal income respond in the short run to changes in government expenditures and taxes. But in economic downturns, countercyclical policies increase government indebtedness, raising future debt service obligations. These new expenditure commitments must be financed by some mix of higher taxes, lower spending, or higher money growth in the future. Expectations of how future policies will adjust change current savings rates and the efficacy of countercyclical policies. It is thus possible for responses to expected future policies to exacerbate and prolong recessions. This paper highlights these expectations effects. Connecting the theory to U.S. data we find: (1) through this expectations channel, countercyclical policies may create a business cycle when there would be no cycle in the absence of countercyclical policies; (2) nontrivial fractions of variation in investment and velocity can be explained by variation in macro policies alone---without any nonpolicy sources of fluctuation; and (3) persistence in key macro variables can arise solely from expectations of policy.

Joint with Tao Zha for the St. Louis Fed's October 2000 monetary policy conference. We explore two popular approaches to empirical analysis of monetary policy: the New Keynesian and the identified vector autoregression approaches. Stylized models of private behavior coupled with simple rules describing policy behavior characterize New Keynesian work. Vector autoregressions (VARs) consist of minimally identified dynamic descriptions of private behavior coupled with a detailed rule for policy behavior. The simplicity of New Keynesian models aids in communication but leaves the models’ implications vulnerable. The relative complexity and loose identification of behavior in VARs hinders communication of the models’ predictions. By relating the New Keynesian models to identified vector autoregressions, we explore the differences and similarities in the two approaches and assess some of the key conclusions to emerge from New Keynesian research. Published in Federal Reserve Bank of St. Louis Review 83, July/August 2001, 83-110.

Joint with David Gordon and Tao Zha. U.S. velocity of base money exhibits three distinct trends since 1950. After rising steadily for 30 years, it flattens out in the 1980s, and falls substantially in the 1990s. This paper explores whether the observed secular movements in velocity can be accounted for exclusively by endogenous responses to changing expectations about monetary and fiscal policy. We use a model with two key features: a substitute for money in transactions and an array of assets that includes money, nominal bonds, and physical capital. The model maps policy expectations into portfolio decisions, making equilibrium velocity a function of expected future money growth, tax rates, and government spending. When expectations are estimated using Bayesian updating, simulated velocity matches the trends in actual velocity surprisingly well. Published in Carnegie-Rochester Conference Series on Public Policy 49, December, 1998: 265-304. (File in PDF format.)

Joint with Chris Sims and Tao Zha. Presented at the Brookings Panel on Economic Activity, September 8, 1996. Surveys recent literature on identifying the effects of monetary policy using multivariate time series models, and extends the literature by incorporating standard monetary aggregates and reserves variables simultaneously. Concludes that the size of monetary policy effects is uncertain. Published in Brookings Papers on Economic Activity 1996:2, 1-78. (File in PDF format.)

Joint with Jon Faust. Many recent papers have identified behavioral disturbances in vector autoregressions by imposing restrictions on the long-run effects of shocks. The paper demonstrates that this approach will be unreliable unless the underlying economy satisifes three types of strong restrictions. While many aspects of these issues have been raised before, this paper draws out and illustrates the implications for inferences under the long-run scheme. Further, the paper provides strategies for dealing with the problems. Published in Journal of Business & Economic Statistics 15, July, 1997: 345-353. (File in PDF format.)

Romer and Romer (1989,1994) adopted a "narrative approach" to address the identification problems in time series models of monetary policy. Based on Federal Reserve documents, the Romers created a dummy variable equal to one in periods when the Federal Reserve contracted to offset inflationary pressures. This paper shows that (1) the dummy variable is predictable from past macroeconomic variables, reflecting the endogenous response of policy to the economy; (2) unpredictable changes in the dummy do not generate dynamic responses that look like the effects of monetary policy. The identification problems that plague time series models also afflict the narrative approach. Published in Journal of Monetary Economics 40, December, 1997: 641-658. (Zipped file containing Word document and RATS .rgf files.)

(file compressed in Unix; to uncompress use gzip -d filename) This appeared in the Atlanta Fed's Economic Review, July/August 1993. This article considers monetary and fiscal policy jointly. Policy effects emerge and some findings that challenge such long-cherished generalizations as, "When Congress increases taxes, the economy will grow more slowly" or "If the Fed expands the money supply, inflation will pick up." The systematic approach used shows that the traditional beliefs about policy effects embody implicit assumptions about how the two policies interact. When those assumptions hold, the traditional beliefs are true. Under different, equally plausible assumptions, however, those beliefs can be false.

Monetary and fiscal policy interactions are studied in a stochastic maximizing model. Policy is ‘active’ or ‘passive’ depending on its responsiveness to government debt shocks. Schemes for financing deficits and, therefore, the existence and uniqueness of equilibria depend on two policy parameters. The model is used to: (i) characterize the equilibria implied by various financing schemes, (ii) derive policies where fiscal behavior determines how monetary shocks affect prices, and (iii) reinterpret Friedman’s 1948 policy framework. The paper reconsiders the result that prices are indeterminate when the nominal interest rate is pegged. The setup can be used to interpret reduced-form studies on fiscal financing. Published in Journal of Monetary Economics.

Joint with Beth Ingram. An increasingly popular approach to policy evaluation involves applying the parameters calibrated for a real business cycle model that does not include policy to a different model, where policy does affect private decisions. This technique, in effect, estimates a model that misspecifies how private behavior depends on policy. The calibrated parameters depend on policy behavior, but calibrators overlook this dependence when projecting policy effects. This procedure repeats the "Keynesian" errors that Lucas (1976) noted in his influential critique of (then) standard methods of econometric policy evaluation and produces predictions of policy consequences that may be no more useful than ones from traditional econometric models.

(file compressed in Unix; to uncompress use gzip -d filename) This is the working paper version of my 1991 Journal of Monetary Economics paper. It appears here because this version includes some empirical implications of interactions between monetary and fiscal policy when private agents have some degree of foreknowledge about fiscal policy. This is a 1990 working paper that is occasionally requested.

(file compressed in Unix; to uncompress use gzip -d filename) This paper combines interactions between monetary and fiscal policy with the realistic assumption that private agents have some degree of foreknowledge about fiscal policy to illustrate the potential difficulties in unraveling monetary and fiscal policy impacts. This is a 1989 working paper that is occasionally requested.

Talks and Discussions of Papers

Plenary talk at the Missouri Economics Conference, March 28, 2009. Explains that price-level determination and, therefore, aggregate demand determination, is fundamentally a monetary and fiscal policy phenomenon. Because monetary and fiscal policy regimes in the United States exhibit recurring changes, fiscal policy always has impacts on aggregate demand. Accounting for monetary-fiscal interactions and the possibility of regime change dramatically alters inferences about the efficacy of stimulative fiscal actions. The talk also assesses a stylized version of the the American Recovery & Reinvestment Act of 2009.

Invited lecture as Professorial Fellow in Monetary and Financial Economics, Victoria University at Wellington and the Reserve Bank of New Zealand, November 12, 2008. Over the past 15 years, central banks' modus operandi has shifted from “monetary mystique” to a “culture of clarity,” a movement in which the Reserve Bank of New Zealand has been at the vanguard. Now the modal view is that transparency and accountability of monetary policy are unambiguously desirable. This revolution in thinking about monetary policy has generally not been accompanied by a corresponding enlightenment in governments’ tax and spending policies—fiscal policies remain nearly as opaque as ever. In this talk I develop the argument that there are striking parallels between monetary and fiscal policy. Both macroeconomic policies: can control the inflation rate and affect economic activity; operate at least in part by influencing economic decision makers' expectations; can ensure that the government is solvent; are more effective when they are transparent and credible. In light of these parallels, it is remarkable how many countries have undertaken dramatic reforms in monetary policy while making little or no reform to fiscal policy. This asymmetric treatment runs the risk of undermining the efficacy of the monetary reforms and the ability of central banks to target the inflation rate. I also argue that, as with monetary policy, uncertainty about future fiscal policies increases macroeconomic risk and is socially costly.

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Talks and Discussions of Papers